As Some Prepaid Tuition Plans Struggle, Is Your Money at Risk?

Is there anything scarier in the world of personal finance than saving for college? Parents want to be ready, but we have no idea how much will be covered by financial aid, or how our investments will perform between now and freshman convocation.

Worst of all, we don’t know how much the price of college will increase. Save all you want, sucker. You’re walking down the up escalator.

Prepaid tuition programs can alleviate some of the uncertainty. Unlike 529 savings plans, where parents invest their dollars in the stock and bond markets and ultimately bet their kids’ education savings on market performance, prepaid 529 plans allow parents to purchase future tuition credits (or units) in advance. In other words, pay a set price (not necessarily today’s tuition) now and be guaranteed that, come college time, your son or daughter will have a guaranteed amount of already paid-for tuition credits.

Of course, every guarantee comes at a cost, and in the case of prepaid 529 plans what you gain in security, you lose in flexibility. Unlike 529 savings plans, prepaid plans are generally open only to residents of the state that operates the plan. All prepaid plans allow you to use your units at a private or out-of-state school, but some penalize you for doing so. Only a handful of states (see below for a list) even offer a prepaid plan. And you naturally give up the chance to have your investments outperform the rate of tuition inflation… but good luck with that in any case.

These plans hold about 16% of the nation’s tax-advantaged college savings—about $21 billion—according to 2010 data from the College Savings Plans Network, and 11 states currently operate prepaid tuition programs that are open to new members. I signed my daughter up for Guaranteed Education Tuition (GET), Washington State’s program, when she was a baby.

Scary stories

So you decide that a prepaid tuition plan will help you sleep at night. Then you turn on the news and hear that your state’s prepaid plan is running into funding trouble. A majority of all prepaid plans have hit some kind of fiscal crisis, and many have had to close to new contributions.

Case in point: last week’s Seattle Times wrote of a “looming financial cloud” over the GET program and three Washington state senators introduced a bill that would close the program (with no loss to current participants) and establish a new GET 2 program with less generous terms.

But these scary stories conflate the issue of risk to the state budget with risk to you, personally. What you want to know is…

Is my money at risk in a prepaid tuition plan?

The short answer: That’s extremely unlikely.

“Every state that’s run into problems has taken pretty extraordinary measures to ensure that people were not really losing money with their investments,” says Joe Hurley, who runs SavingForCollege.com, one of the premier online resources for 529 plans. That means prepaid plans have a better safety record than the more popular investment-type 529 plans, some of which took a major hit to their supposedly-safe assets in the 2008 crash.

Some states, including Washington, guarantee their prepaid plans with the full faith and credit of the state or with a similar legislative guarantee. The states with open, guaranteed prepaid plans are Virginia, Maryland, Massachusetts, Mississippi, Florida, and Washington. (States without a guarantee: Michigan, Nevada, Illinois, Pennsylvania and Texas.)

Regardless of whether there’s an explicit guarantee, however, messing with people’s college savings is political dynamite. “I think it’s very difficult, if you’re a state representative, to say that you’re not going to fund this, when this supports families saving for education for their children,” says Joan Marshall, director of Maryland’s college savings plans and chair of the College Savings Plans Network.

In Texas, for example, parents raised a Texas-sized ruckus (32,000 phone calls!) when the legislature proposed to reduce the refund value of unused prepaid units. And this only affected leftover units—not the ability to redeem them for college credits. Faced with the prospect of furious parents with pitchforks, the state quickly backed down. Faced with the prospect of furious parents with pitchforks, the state quickly backed down.

Still, financial worst-case scenarios can and do happen. “Can I make promises? No,” says Marshall. “Can any state official make those promises? No.”

Much more likely than actually losing your money is the prospect that your state will cancel or water down its prepaid tuition plan before your child is ready for college.

Fearing such a change in the future, many parents figure they should grab some prepaid units now, before the state realizes it’s offering a sweet deal. (This doesn’t mean that every prepaid plan is a great deal; some charge a huge premium based on an assumption of large future tuition increases or have confiscatory penalties.)

In the case of Washington’s GET plan, media coverage is scaring people right into the plan before the legislature can monkey with it. “I think we’re going to have our biggest year ever,” says Betty Lochner, director of GET. “We couldn’t buy this exposure that the program’s getting through the concerns of the legislature.”

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.